In Route 231, LLC v. Commissioner, 117 AFTR 2d 2016-XXXX (4th Cir. 2016), the U.S. Court of Appeals for the Fourth Circuit held that certain funds received by the taxpayer constituted income from the sale of Virginia land conservation tax credits rather than capital contributions to the taxpayer.
The taxpayer (“Route 231”) was a Virginia limited liability company initially owned by two individuals. After its formation, Route 231 acquired two pieces of Virginia real property. Route 231 then decided to donate some of the property for conservation purposes. At that time, taxpayers could obtain a Virginia income tax credit equal to 50% of the fair market value of land donated for conservation purposes. Using a consultant, Route 231 found Virginia Conservation Tax Credit FD LLLP (the “Investor”). The Investor eventually became a 1% owner of Route 231 in exchange for a payment to Route 231 of $3,816,000. The Investor and Route 231 characterized this payment as a capital contribution on their federal income tax returns. Although the Investor was only a 1% owner, Route 231 allocated 97% of the Virginia tax credits to the Investor. The IRS subsequently determined that the Investor purchased the Virginia tax credits from Route 231 for $3,816,000 and that Route 231 erroneously characterized this amount as a capital contribution.
Generally, a partnership does not recognize income when a partner makes a cash contribution to a partnership. However, if a partner transfers money to a partnership and there is a transfer of money or other property by the partnership to such partner, the two transfers may be re-characterized as a sale or exchange of property rather than a tax-free contribution to the partnership followed by a distribution to the partner; the two transfers are presumed to constitute a sale or exchange if they occur within a two year period. These re-characterization principles generally are referred to as the “disguised sale rules.”
The court first concluded that the Virginia land conservation tax credits constituted property for purposes of the disguised sale rules, largely because of the economic value of the tax credits to the Investor. The court then acknowledged that the transfer of $3,816,000 to Route 231 and the transfer of tax credits by Route 231 to the Investor occurred within a two year period; accordingly, there was a presumption that the two transfers constituted a sale of property rather than a tax-free contribution. The court further stated that the following facts and circumstances supported a finding that the transfers constituted a sale: (1) the fixed contribution amount of 53 cents for each dollar of Virginia tax credit to be allocated to the Investor; (2) the Investor’s contractual right to Route 231’s tax credits; (3) the Investor’s right to be indemnified if it did not receive all of the promised tax credits; (4) the disproportionate allocation of tax credits to the Investor (compared to its ownership interest); and (5) the Investor’s ability to exercise full ownership of the tax credits once received. The court concluded that these factors showed that the Investor would not have transferred the $3,816,000 without the corresponding transfer by Route 231 of the credits and that Route 231’s transfer of the credits did not depend on the entrepreneurial risks associated with a typical partnership investment. Accordingly, the transaction properly was characterized as a sale rather than a tax-free contribution to capital.
Real estate professionals should be aware of the Route 231 case as well as the IRS’s and courts’ ongoing interest in tax credit transfer transactions. Although the IRS has published guidance in Revenue Procedure 2014-12 that provides a safe harbor for similar transactions involving historic tax credits, it currently is unclear whether the IRS’s guidance also applies to other types of state tax credits. Accordingly, real estate professionals involved in these transactions should consult with a tax advisor.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.
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